The personal side of personal finance can be messy — emotions, justifications, excuses and temptations are all strong forces that threaten to disrupt the delicate balance that is your personal balance sheet.
Sometimes the best strategy is to stay focused on the numbers themselves. That’s why we sometimes rely on emotion-free numbers and formulas that aren’t as fickle as we are.
Let’s take a look at some formulas you can use to see your personal finances in black and white.
1. Cash Flow
This basic formula is the definitive measure of living within your means. If you have a negative cash flow, you’re spending more than you’re bringing in — a clear indication it’s time to reassess your earning potential or cut back on spending.
2. Leverage Ratio
The leverage ratio is an assessment of your debt in proportion to your income. Experts recommend a leverage ratio of no more than 33 percent of your income, though the lower ratio, the better your overall financial health. This calculation will be an important factor in deciding whether you can afford to take out a loan like a mortgage.
The closer you are to zero, the better.
- A = Payment amount per period (week, month, year, etc.)
- P = Initial principal (loan amount)
- r = interest rate per period (as decimal; ex. .12 would represent 12 percent interest)
- n = total number of payments
From the Latin for “to kill,” amortization means paying off long-term debts like mortgages and student loans over time, where payments apply to both interest and principal.
Using the formula above, you can figure out your total monthly payment accounting for both principal and interest given a certain time frame.
Say it was supposed to take you five years to pay off your car loan, but you want to do it in three. The amortization formula will help you determine if you can afford to make the extra payments each month to speed up the payoff.
This formula becomes especially helpful when you’re in the market for a new auto loan.
4. Compound Interest
- A = Money accumulated after t years (or any other time period)
- P = Principal (original amount of money invested)
- r = Interest rate (as decimal)
- n = number of times interest compounds each period t
- t = number of years (or any other time period)
The compound interest formula shows you the exact future value of any money accumulating interest, such as a savings account, CD or investment (although here it would be just an estimate excluding marketing fluctuations).
Watching the power of compound interest work in your favor can be an exciting incentive to dedicate more to savings and investments. Conversely, watching compound interest accrue on your debt and working against you can be the motivation needed to pay down what you owe ASAP.
The great thing about compound interest is you’ll exponentially make more money each year. For example, a savings account accruing 1 percent interest per year will grow significantly more in its 30th year as opposed to its first.
This is why so many financial gurus encourage young adults to begin saving and investing as early as possible.
If you make regular payments into an interest bearing account, replace P with (P+xt) where x represents how much you contribute per t (years, months, etc.)
5. The Rule of 72
- R = Interest rate (as a whole number)
- Y = Number of years until investment doubles
The rule of 72 tells you how long it will take you to double an investment accruing compound interest, helping you quickly compare returns from different interest rates while taking into account the effect of compounding.
For example, if you invest in a savings account with a 2 percent interest rate, it would take you 72÷2, or 36 years, for your original investment to double.
You also can use the rule of 72 in reverse to account for inflation. Assume you stash money under your bed where it doesn’t accrue interest — if inflation stays at 2 percent in the future, your money would have half its original value after 36 years.
While excuses, justifications, and the like help you avoid confrontation with your financial reality, you can’t hide from the numbers. And maybe that’s not such a bad thing.
Photo credit: docsity.com
Formula credits: codecogs.com